Hedging Real Estate Risk: Using Real Estate Derivatives

Objectives
Understand the background and common types of derivatives and discuss the types and uses of real estate derivatives Discuss the real estate derivative products that are currently in use. Discuss the mechanics of a real estate return swap Understand the risks involved in a real estate derivative Know how to use derivatives to reallocate and rebalance a real estate portfolio Work through a hedge illustration using a return swap.

Basics of Real Estate Derivatives

Background on Derivatives
Derivative is a financial instrument whose value depends on the values of other, more basic underlying variables. For a real estate investor, the underlying variable would be the value of the real estate The underlying variable is often a traded asset, such as a stock or commodity, but it can also be an index. For a real estate investor, the index may be the NPI, IPD or some other index Derivatives are generally used as tools for isolating and pricing financial risks involved with holding the underlying variable. For a real estate investor, the risk is that the value of their real estate holdings will decline.

Common Types of Derivatives

Forward contract agreement to buy or sell an asset at a certain future time for a certain price. Is applied in direct real estate investment as a forward purchase agreement. Futures contract similar to a forward, but deal terms are highly standardized and contracts are traded on exchanges. These are not commonly used in private real estate investment. Option contract gives the holder the right, but not the obligation to buy or sell a specific quantity of an underlying asset at a specified price at some point in the future. Swap two parties agree to exchange cash flows according to a specified procedure, with no cash exchanged up front.

Real Estate Derivatives

Based on composite real estate market performance as measured by indexes. They offer a synthetic means to invest in the private real estate market. The synthetic nature of the investment has several attractive characteristics that may benefit real estate investors.

Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

Hedging Risk: Applying Derivatives to Real Estate Investments

Hedging a commercial real estate portfolio using real estate (property) derivates involves either taking a short position on a real estate index using a total return or appreciation swap. This strategy is similar to portfolio insurance and protects the portfolio from downside risks. Real Estate derivatives can be used to effect asset allocation and rebalancing as a strategy that allows portfolio managers to execute strategic or tactical asset allocation decisions in a faster and more cost-efficient way than has ever been possible. Real Estate derivatives can be also be used for speculation, rather than hedging strategy that leverages the forward looking views and forecasts of a firm to take long or short positions.

Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

Benefits of Real Estate Derivatives

Quick Execution sourcing and executing private real estate investments is a time-consuming process. Property derivatives offer quick execution, which could benefit investors by allowing them to act on new information, strategies, or allocation preferences immediately. Low Transaction Costs round-trip transaction costs on direct investment are approximately 6-8% in the UK, and 3-8% in the United States. Derivatives costs would be lower and could therefore help to improve returns. Short Positions taking a short position on the private real estate market has generally not been possible. Property derivatives enable the use of strategic hedging, which can protect the value of portfolios.
Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

Benefits of Property Derivatives

Flexible the size, length, and structure of property derivatives contracts can be tailored to meet individual needs. This gives investors flexibility to meet specific investment objectives and more easily achieve asset allocation targets. Diversified because property indexes measure aggregate market performance, investment in property derivatives does not include property or site-specific risks.
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Real Estate Derivative Products and Mechanics

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Real Estate Derives: Products Currently Offered

NPI Appreciation Swap for Fixed NPI Total Return Swap for Fixed NPI Property Type Total Return Swap Similar products on IPD in U.K.

Source: Geltner & Miller, 2nd Edition, South-Western

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Total Return Swap Derivatives: Mechanics

The most prevalent real estate derivative structure is the total return swap. A total return swap involves one party paying the total return of an asset or index to another in exchange for a fixed or floating rate payment.
Fixed Rate Bid Fixed Rate Offer

Investor B
(Hedge/Short Position) Index Return

Investment Bank
(Market Maker) Index Return

Investor A
(Long Position)

Profit from Spread = Offer rate Bid Rate 12

Total Return Swap Derivatives: Mechanics

Motivation Investor A believes that the real estate index will outperform the markets expectations and, therefore, wants to take a long position. Investor B believes that the index will under perform expectations and, therefore, wants to take a short position (either as a hedge on underlying real estate holdings or as a speculative play). Pricing an investment bank (or other market maker) brings the two sides together by setting a price: Investor A (long position) agrees to pay a fixed percentage rate (offer) of a referenced notional principle amount (or receive a rate if the quoted rates are negative) in exchange for a cash floe that is the index total return percentage of the notional amount. Investor B (short position/hedge) agrees to pay the index total return percentage in exchange for the fixed rate (bid).

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Total Return Swap Derivatives: Mechanics

Result investor B has locked in a fixed rate of return and is protected from the market performing below expectations in exchange for any potential upside. Investor A gains exposure to future market movements; if the market performs below expectations, he will lose money, but if the market performs above expectations, he will make money.
The market maker profits from a spread between the bid and the offer rates. Investor A is selling return insurance by participating in the upside. Investor B is buying return insurance by giving up the upside.
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Risks in Derivative Products

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Liquidity Risk
Lack of market liquidity could seriously constrain a market participants ability to sell a position at a fair value. There may only be one bank active in making a market for these products, if any. Due to the low liquidity of the property derivatives market, the price discovery mechanism may not function reliably. This could push market pricing to levels inconsistent with property market fundamentals or hypothetical swap market equilibrium pricing.
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Basis Risk
Type 1 The risk that the value of a financial instrument does not move in line with the underlying exposure. For a hedging strategy to be effective there should be a high correlation between the underlying exposure (a real estate portfolio) and the hedging instrument (contract based on a real estate index). The hedge is only effective if these move together closely. Type 2 Each property index attempts to derive theoretical value and price changes in real estate markets. Because there are methodological problems with every available index, there is the risk that the value changes measured by the index are different from the actual price changes in the real estate market.
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Counterparty Risk
The risk that the counterparty to a trade will no make the expected payments Exchange-traded markets eliminate virtually all counter party risk by requiring daily cash settlements.

Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

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Interest Rate Risk

Market prices of property derivatives are ultimately based upon interest rates specifically LIBOR (London Interbank Offered Rate). Movements in interest rates will affect swap prices. Unless interest rate risk is hedged away, a swap contract contains an embedded bet on the future direction of interest rates.

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Derivative Products: Reallocation and Rebalancing

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Allocation and Rebalancing

Inefficiencies in the private real estate market make strategic asset allocation difficult to execute in a timely manner. Property derivatives offer efficient access to real estate market exposure, which can facilitate more efficient portfolio management strategies, such as diversification, asset allocation, and portfolio rebalancing.

Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

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Allocation and Rebalancing

Diversification Diversify holdings regionally, internationally, or by asset class. Assembling a diversified real estate portfolio is a very difficult, expensive, and time-consuming process. An index offers diversification that is much faster and easier than direct investment, because the index tracks a large number of properties. Also, index exposure can be purchased in small sizes, where a diversified real property portfolio is inherently large.
A diversification strategy would be most appropriate for smaller portfolios that are heavily weighted in a few regions or sectors due to their small size. Accomplished by going long on commercial property index with a total return swap, buying futures, or buying options.
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Allocation and Rebalancing

Asset Allocation gain short-term access to specific asset classes, regions, or markets based on macro level outlook. Portfolio managers who wish to make tactical investment decisions could use property derivatives to execute these strategies quickly and with minimal costs. It would be useful for gaining access to specific regions, property types, or markets when acquisition of quality assets in the real property market is difficult. The strategy would also be appropriate for disposition, as exposure to markets or asset classes can be reduced without having to sell a trophy building. This strategy would be appropriate for all funds regardless of size or scope. Accomplished by going long or short on commercial property index with a total return swap.
Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

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Allocation and Rebalancing

Portfolio rebalancing adjust portfolio weights by sector or asset class to maximize risk-adjusted returns. Based on portfolio analytics, recommendations can be made on adjustments between sectors or regions to move the portfolio closer to its efficient frontier.
This strategy would be most appropriate for large diversified portfolios. Accomplished by going long or short on a commercial property index, or swapping between two regional or sector specific indexes, using total return swaps.
Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak, Tim Wang, and David Lynn

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Total Return Swap, Apartment for Retail

3.25% + Ret

Real Estate Investor

2.5% + Apt 0.75%+(Ret - Apt ) +

Investment Bank

Counterparty

Retail Alpha ()
Apartment Alpha ()

Retail Beta ()
Apartment Beta ()
Fund Portfolio

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Illustration

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Hypothetical Portfolio Hedge

An investor with a hypothetical portfolio highly correlated to the NPI decided to hedge the portfolio by taking the short side of an NPI capital return swap in June 2007. At that time, the midpoint pricing to short the NPI capital return was 2.5% per year. During third and fourth quarters of 2007, the hypothetical swap resulted in negative net cash flow, but the cash flow turned positive in the first quarter of 2008. Midpoint pricing for the NPI capital return declined from 2.5% in June 2007 to -8.5%in July 2008. Because of this, the hypothetical future cash flows became much more valuable, with a net present value of about $1.6 million (Exhibit 12.10). The investor can sell his position for a profit, unwind the position to lock in a fixed rate of return for the remainder of the contract, or hold the contract until expiration. The proceeds of the hypothetical hedge transaction could go toward paying investor redemptions, protecting a promote threshold, or supporting fund returns.
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Quarterly Cash Flow for Short Position

Notional amount: Margin Fixed spread: Term: Quarter ending: NPI Capital Return: Fixed Spread: 9/30/07 2.25% 0.63% $10,000,000 $300,000 2.50% 2 years 12/31/07 1.86% 0.63% Starting 9/30/07 ending 6/30/09 3/31/08 0.34% 0.63% 6/30/08 -3.07% 0.63% 9/30/08 -3.07% 0.63% 12/31/08 -3.07% 0.63% 3/31/09 -2.16% 0.63% 6/30/09 -2.16% 0.63%

Short side cash flows (receives fixed spread, pays NPI Capital Return) Fixed Spread: NPI CR: Net Cash Flow: Sum of past cash flows: NPV of future cash flows: $62,500 $(225,000) $(162,500) $62,500 $(186,000) $(123,500) $(257,500) $1,577,406
Reported NPI returns shaded; implied NPI returns unshaded.

$62,500 $(34,000) $28,500

$62,500 $307,167 $369,667

$62,500 $307,167 $369,667

$62,500 $307,167 $369,667

$62,500 $215,625 $278,125

$62,500 $215,625 $278,125

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Sources
Fabozzi, F., Shiller, R., & Tunaru, R. (2009) Hedging real estate risk. Institutional Investor, Inc.,Special Real Estate Issue 2009. Geltner, D., Miller, N., Clayton, J., & Eichholtz, P. (2007) Commercial real estate: analysis and investments (2nd ed). Mason: Thomson Southwestern. Contact: Cengage Learning, Inc. P.O. Box 6904 Florence, KY 41022-6904 Lynn, David J. (2009). Active private equity real estate strategy. Hoboken: John Wiley & Sons, Inc. Contact: John Wiley & Sons, Inc. 111 River Street Hoboken, NJ 07030-5774

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